Economic Logic, Too

About Me

I discuss recent research in Economics and various events from an economic perspective, as the name of the blog indicates. I plan on adding posts approximately every workday, with some exceptions, for example when I travel.

Thursday, July 31, 2008

I cannot decide whether the new housing aid bill is good or bad. Here is why.

Given the current situation and the number of foreclosures, the forced moves of households and forced sales of homes generate huge transaction costs. They stem from disrupted lives, moving costs, loss of equity, empty houses depreciating, etc. We all know how costly it is to change homes. Imagine do this on short notice and multiply this by a large number. And on the banks' side, their loss of capital (as homes lose value and debt goes bad) hinders them to give credits that could be productive for the economy. And banks have to devote resources to manage the foreclosures. The housing aid bill avoids many of these costs by keeping people in their homes.

However, bailing out homeowners and banks comes at a significant reputation cost for the government. As many have pointed out, this bill rewards the absence of personal responsibility. Those who were responsible will have to ultimately foot the bill. As in many other examples, if the government shows that it is tough in such situations and does not act as a lender of last resort, such situations would never happen. Well, they still may happen if there is limited liability (but less frequently), hence the need for some regulation. But essentially a tough government leads to self-restraint.

In other words, we have a situation that can be improved, but we also face a time consistency problem. The ideal would be that somehow the government would be able to state that it would be helping this time, but never again. This administration being at the end of its term may help, but presidential candidates have shown no sign of a commitment to toughness.

Wednesday, July 30, 2008

No, this is not about the industry that produce toilet seats, but rather about the habit for men to leave the toilet seat up. Hammad Siddiqi analyses this problem from a game theoretic point of view. Let me quote the entire abstract:

We model the toilet seat problem as a 2 player non-cooperative game. We find that the social norm of leaving the toilet seat down is inefficient. However, to the dismay of “mankind”, we also find that the social norm of leaving the seat down after use is a trembling-hand perfect equilibrium. Hence, sadly, this norm is not likely to go away.

It appears there is a literature on the subject: Jay Pil Choi argues that the selfish rule of leaving the toilet seat how one prefers it is the most efficient one. Any other rule (always up, or always down) inconveniences each member of one gender twice on each bathroom trip. With the selfish rule, one may not need to alter the seat, depending who came before, and never alters it after doing one's business. The always down rule is only efficient if the inconvenience to females is much larger than to males.

Hammad Siddiqi argues that a crucial element is missing from this analysis: conflict, or in other words game theory. One could do it like in a cooperative game, like Richard Harter. This assumes that members of a household minimize the joint cost of toilet seat moving. But what if they act selfishly, and possibly strategically?

Within a non-cooperative game, player can inflict penalties on others. In this case it would be females yelling at males for leaving the seat up. While leaving the seat always down remains inefficient, as in the two previous analyses, it is now a Nash equilibrium. There are often many such equilibria in a game, so this does not say much. But it is also trembling-hand robust, which means it is still the best strategy if the man (or the woman) sometimes forgets. Hammad Siddiqi concludes by asserting that if females realized that the always-down rule is inefficient, they would stop yelling and allow for a better strategy. There is hope.

Tuesday, July 29, 2008

Publishing in Economics is also a lot about marketing your results. It is thus no surprise to me that US Economists dominate this profession: Americans are simply better at selling. One particular aspect of this marketing is the title of your paper. It pikes the interest of the potential reader.

One master of the art of title writing is Daniel Hamermesh. Here is a sample of his research:

Strike Three: Umpires' Demand for Discrimination

Cues for Coordination: Light, Longitude and Letterman

Changing Looks and Changing "Discrimination:" The Beauty of Economists

The Economics of Workalcoholism: We Should Not Have Worked on This Paper

The Value of Peripatetic Economists: A Sesqui-Difference Evaluation of Bob Gregory

Beauty in the Classroom: Professors' Pulchritude and Putative Pedagogical Productivity

Dress for Success -- Does Primping Pay?

Shirking or Productive Schmoozing: Wages and the Allocation of Time at Work

How ‘Grievous’ Was the Biblical Famine?

12 Million Salaried Workers Are Missing

When We Work

Of course, Hamermesh has a tack fro quirky research topics, which helps in finding original and intriguing titles. I notice also that his early work did not have much originality in the titles. I conclude this comes with experience, or with tenure.

Monday, July 28, 2008

Zimbabwe is in a truly horrible situation, including crippling hyperinflation. I am not quoting any numbers here, they would be obsolete to quickly... Mugabe has royally mismanaged his country, but he is not eternal. So, once the economy is half-way decently managed, how could one get out of hyperinflation?

The obvious answer is of course: stop printing money. But this is not that easy. Without confidence in the currency, prices will continue to rise, at least for a while. Government expenses still need to be met in the meanwhile, in particular civil servants, and there is no meaningful way to raise taxes. But even with a sound fiscal policy, there is no guarantee that hyperinflation can be beaten. For example, Beatrix Paal shows that a policy of stabilizing inflation though the management of public debt is essentially indeterminate and can lead to hyper-inflation, thus being ineffective. Thus, the critical point is to restore confidence in monetary policy while continuing to pay for government services.

Makinen and Woodward show that Taiwan managed to beat hyperinflation by guaranteeing high real interest rates on bank accounts. This seems like classic anti-inflationary monetary policy to the extreme.

I think the best solution is to delegate monetary policy to an entity outside of the country. This is what Cooper and Kempf advocate: dollarization or a currency board. Dollarization means abandoning local currency in favor of another one. But if one ultimately wants some control over monetary policy, this does not sound like a good policy.

In a currency board, the exchange rate with a base currency is set by law, thus difficult to change unlike a fixed exchange rate regime. In addition, every bit of currency in circulation is backed by the base currency (or titles in said currency): anybody can exchange at the predetermined rate at the central bank. Such currency boards have been very successful in creating confidence in the local currency in various countries from the former Eastern European Block, where the IMF helped building up the necessary foreign reserves. So far, the only currency board that failed was the Argentinean one, due to unsustainable local fiscal policy.

A currency board has worked superbly to end hyperinflation in Bulgaria, as shown by Stefka Slavova. But as the Argentinian example shows, and as Thomas Sargent argues in a celebrated book, sound fiscal policy is still needed from the start, but it is not sufficient, as also Gustavo Franco showed.

Friday, July 25, 2008

One of the roles of the IMF is to make assessments of economic policies in member countries and forcing them to adopt sounder ones. The important word here is "forcing." Many governments are in fact grateful for this, as it allows to enforce good, but unpopular policy using the IMF as a scapegoat.

In principle, any member country could be subject to such scrutiny. Unfortunately, there is considerable politicking in the IMF, and in particular rich countries manage to impose upon others prescriptions they would adopt themselves. They can get away with it due to current structure of the IMF. We reported before on the need for this structure to be reformed.

In turns out the US will be scrutinized soon within a Financial Sector Assessment Program (FSAP), i.e., a complete analysis of the financial sector. Market participants and government agencies will be required to hand over confidential documents. This is no different than what is done elsewhere, but the uproar is certain to appear.

One could view this as a sign that finally rich economies are coming under the same scrutiny as the poorer ones. Not quite. Indeed, this mission had been on the radar for a long time, but the Bush Administration vehemently opposed it for seven years, but finally gave in on the condition that the report be issued after the handover to the next administration. By then, everyone in charge will be out of office, but one: Ben Bernanke.

Thursday, July 24, 2008

The US Congress has finally found the scapegoat for high oil prices. While most of the increase is due to the fall of the US dollar that will eventually rectify itself, it found speculators to be guilty and intends to rein them in. This is nonsense.

Speculators are regularly vilified because they manage to make money without being apparently productive. Yet, they provide some very important functions on the market: they help hedging against risks, and more importantly, they help prices being informative of true economic conditions. Through their arbitraging, they make sure that goods are properly priced. For example, if an under-supply of oil is expected, they make sure that the price of oil reflects this. This allows producers and consumers to adjust to conditions. If prices would not reflect markets conditions, rationing could appear.

Yet it seems Congress wants exactly that: prices that do not reflect economic conditions. The current proposal is to inhibit the ability of speculators to arbitrage by preventing them to resell (which is at the core of arbitraging) and to deal with foreign markets.

There is no question that whenever markets are manipulated, intervention is necessary. How do you define manipulations? Albert Kyle and S. Viswanathan define a two-pronged test: Price manipulation needs to simultaneously undermine both pricing accuracy and market liquidity. In other words, their is manipulation if prices do not provide signals about economic conditions while there is evidence that someone is preventing trades from happening. Prices could be poor signals in liquid markets, but their is nothing one can do and nobody is benefiting from it. Prices can be accurate in illiquid markets, and that is not a problem. But both happening at the same time is a sign of manipulation.

Are oil prices currently manipulated? Given the size of the market, this is unlikely. But it has happened before, for example when the Hunt brothers manipulated the silver bullion market in 1979-80. At that time, they severely curtailed the liquidity of the market by hoarding. That does not seem to be the case with oil today. Oil markets are very liquid, and prices do reflect a real scarcity in addition to risk.

Note that what Congress proposes would be considered price manipulation, as transactions are prohibited (which lowers market liquidity) and prices likely would not reflect economic conditions (which undermines pricing accuracy). In other words, the proposal would make things worse... But it is responding to the call of doing something, and this is what counts in politics, right?

Wednesday, July 23, 2008

The increase in oil prices allows nicely to highlight the mechanics of substitution. The increase in the price of most goods lead to a decrease in its use, while increasing the demand for its substitutes. This leads to an increase in the price in the other goods. We have seen this in the past month nicely with increases in electricity and food prices, although these are not pure substitution effects (oil is at least partly an input).

Another substitution effect come form the use of goods that were not used before. In the case of energy, using alternatives like solar energy or windmills becomes more economical, thus creating goods that were not in demand before. But again, this is not a pure substitution effect, because these alternative energy sources have been pushed for other reasons as well, such as pollution reduction.

For automobiles, the rise of hybrid cars is a substitution effect, although they still use some gas. What about a car that does not use energy from oil at all? Enter the AirCar, which simply runs on compressed air. The concept is ten years old, but was not economical until now (except for some cars running in Spain). Tata Motors, the major Indian car manufacturer now announced it will start producing a car based on this concept in August 2008. The MiniCAT will have a range of 300km for a maximum speed of 105km/h, the refill will come to $2.00 at a station, and an emergency compressor can be plugged into a socket to refill as well.

Note that this car does not use the air pressure per se, but rather the thermodynamic effect when you change the pressure and the volume of the air. The emissions are thus only very cold air, which can be used for air conditioning...

Tuesday, July 22, 2008

CD sales are down, and the music industry is complaining it is losing out with the online business (the legal one and the illegal file-sharing). It turns out the music industry could do much better with its online business if it just tried a little bit harder.

Benjamin Shiller and Joel Waldfogel show that price discrimination could improve profits by 10% while increasing consumer surplus, a win-win scheme. The idea is very simple. The current uniform pricing at $0.99 leaves surplus on the table for some songs were people would be willing to pay more, while a lower price for some songs would increase sales significantly. In addition, by offering various bundling scheme, it is possible to increase sales and surplus simultaneously.

Specifically, they consider component pricing (prices differentiated by song, but not consumer), pure bundling (one price for a set of songs, in particular larger sets), two-part tariff (a fixed fee plus a per song price) and nonlinear bundling (fixed fee plus a variable price). Shiller and Waldvogel use survey data on song valuation to establish optimal prices for all schemes, and find that in all cases profits and consumer surplus can be improved.

How long will iTunes maintain uniform pricing? The study show that some songs could be sold at a substantially higher price (for example $4.89 for "See You Again" by Miley Cyrus). Amazon seems to be trying such schemes, but with the competition of iTunes, only discounts will work for the moment...

Monday, July 21, 2008

College is supposed to teach some life skills to students apart from their major, like critical thinking, a general understanding of the world they live in, an appreciation of others and how to function like an adult citizen in our society. Part of this is some general understanding of Economics. This includes foreseeing the consequences of economic actions, understanding the role of interest and debt.

Obviously, many Americans are not very good with the concept of debt and savings. But one could think this pertains to uneducated people. Not so apparently, according to an article in the Business Week that even claims that universities team up with credit card companies in trying to lure students into shady contracts. So much for leading by example.

Given that many universities cannot sustain themselves from tuition and state grants, I fully understand that they are looking into alternative sources of funding. One important source is alumni contributions, but screwing alumni like this is no long term solution. Much better would be to actually teach them to understand basic money management skills. They be more successful in life for it, and more grateful.

Friday, July 18, 2008

Real wages have been largely stagnant over the last decades for most workers, except for huge increases for some specialists, like CEOs, athletes and even some academics. Why so? Giuseppe Moscarini offers an explanation: it is all about the corporate culture and how employers chose to match outside offers for their employees or not.

Back in the 1970s, say, it was accepted by all human resource managers that outside offers should not be matched. Knowing this, employees had little incentive to pursue on-the-job searches. If they obtained an offer, the monetary, time and psychological cost of moving jobs (and potentially living quarters) made an outside offer little attractive. As a consequence, wages followed closely productivity.

Suppose now that the employer cannot commit to not match outside offers. Employees will then seek more outside offers, thus generating wage increases through matching. Knowing this, workers are willing to accept lower initial wages, expecting future increases. Wages now are disconnected from productivity.

Note that an employer who has matched an outside offer in the past cannot credibly commit not to match in the future, as its employees are actively seeking outside jobs. Thus matching once leads to an irreversible change in equilibrium.

It remains that for most professions, matching of outside offers in unheard of. But once it happens, expect a sudden boost in wages. Expect no increases thereafter, as firms have exhausted themselves trying to outbid each other.

Thursday, July 17, 2008

Over the past couple of decades, microfoundations have been all the rage in Economics, and in particular in Macroeconomics. The latter relied traditionally on reduced forms, which lead to the Lucas Critique: reduced form elasticities fail to account for elasticity changes that policy shifts can induce. It is now accepted in all fields of Economics that you need to build theory from the ground up, in particular by looking at preferences and constraints.

Of course, the next question is then where those preferences come from and under what circumstances they can change. Too often, the unexplained part in economic behavior is attributed to preference shocks, in part because we do not understand preference formation. Neuroeconomics is about understanding where preferences, and behaviors, come from, and possibly rewrite decision theory from the ground up.

As its name implies, this new field combines Economics and Neurology. It conducts economic experiments, where subjects need to take some decisions while their brain is scanned. Some researchers try to formulate the neurological phenomena during decision taking into formulas, and inferring decision theory from there, or invalidating it.

Wednesday, July 16, 2008

The International Monetary Fund was created in 1944 to encourage policies that lead to macroeconomic stabilization and in particular avert spillovers on other countries. A crucial part was the management of a sound exchange rate system. That was 64 years ago, ans since the role of the IMF has fundamentally transformed itself. As a consequence, it is time to reform it.

While the IMF was initially serving a set of countries that could need its services: countries could be borrowers or lenders. Nowadays it is only serving developing and transition economies, with the developed economies only providing funding. This means that latter cannot be disciplined by the IMF. Furthermore, developed economies can through the IMF set conditions on troubled economies that they would not put on themselves, as they would never get into such a situation. In other words, the initial IMF was working on a principle of symmetry that is lost today. Hence the need for reform.

The solution: give developing and transition economies more voting rights. Currently, they are roughly proportional to the provided funding. The formula needs to be substantially tilted against the rich countries. The latter will be then more reluctant to impose on others what they would not impose on themselves.

Tuesday, July 15, 2008

What is the role of a bank? It takes deposits and lends them to borrowers, typically on business loans or mortgages. The latter have rather long maturities, deposits can be withdrawn at any time. In other words, bank perform a maturity transformation. Doing so, they take the constant risk of not being able to satisfy sudden withdrawals from deposits. Hence the help of central banks as lenders of last resort.

What this means is that no bank is liquid enough to satisfy the withdrawals of all deposits. In fact, if any bank would be able to do so, it would lose money, as it is paying interest on deposits that just sit idle in the vault. Thus any bank risks being subject to a run.

If Senator Charles Shumer reads this, I hope he will come to realize the situation and send letters about every bank in the US, or even every bank in the world, stating that the bank cannot honor deposits. Because this is true, and has always been true.

Friday, July 11, 2008

What is Africa's problem. Many argue it is an issue of governance. One needs proper ownership rights, in particular for land, for an economy to function efficiently and to encourage entrepreneurship. For this reason, international organization, foreign governments and some NGOs insist on a regular basis on governance reform. This is not necessarily a good idea.

William Easterly and Dani Rodrik have for quite a while highlighted that such western style reforms may be ill-suited for developing economies. The main point is that these reforms are not performed in a vacuum. For example, there is typically already a system of ownership in place. It may not use the same institutions as in a Western economy, but it somehow works. Or business contracts are honored through "informal ways", like reputation.

In the latter case, imposing a system with formal courts may backfire: as they enforcement capability may not be high, people may want to opt out of contracts they would have kept in a reputation system. In this sense, the existing system may be a second best institution that would have to be reformed from the bottom up.

Thursday, July 10, 2008

Now that the presidential campaign in the US is getting really serious, and other congressional races are starting to get some interest, once more the talk is about money. Not the money that good policies could generate, but rather that money that candidates manages to raise.

While I can understand that for some trades it is useful to be a good money raiser (charities, religious organizations, i.e., organizations that have little to offer but good feelings), I fail to see how this would help in running a country. The government can finance itself by mandatory taxation, there is no need to coax people into paying. But what is worse is that contributors are expecting, and getting, influence on policy decisions.

Not only is this practice tolerated by the law, it is openly discussed in the US as something that is normal. Yes, this is normal from an economic point of view: one is willing to pay to change a policy as much as the benefit from this policy change. But it is inefficient, for two main reasons: 1) the private optimum may not coincide with the social optimum; 2) the bidding between two lobbyists for opposing may expend huge resources when they outbid each other as each bid is a sunk cost once spent.

It is well known that resources spent on corruption are taken away from productive uses. Political contributions are just the same. They are legal in the US, but that does not make them good.

Wednesday, July 9, 2008

Online games are widely popular, especially MMORPGs (Massively multiplayer online role-playing games) like World of Warcraft, Everquest, Dungeons & Dragons, and Second Life. All of them simulate a virtual world with player interaction, as well as interactions with robots. In most such games, there are markets: players can buy objects, trade with each other, or participate in auctions.

One problem that can arise in such virtual environment is inflation: as players accumulate money, the amount of money in circulation may constantly increase, unless the "government" finds ways to reclaim some of that money. For example, some goods are required for continued play, and their price is preset and may fluctuate. Gaming companies hires economists to handle this (example) and prevent rampant inflation.

Tuesday, July 8, 2008

Typically, who pays income tax where is based on residence. The only country that I know of that does not follow this principle is the United States. As a US citizen (or green card holder), you have to pay income tax to the IRS wherever you live, and on your worldwide income.

Fortunately, many expatriates are able to benefit from some tax treaties between the US and their country of residence: they can deduct their foreign taxes, in principle. But this is by far not the case for everyone. But if you do not live where your taxes are used, what do you get in return for your taxes?

Depending where you live, the US offers protection: an embassy where one can find refuge, or repatriation to the US in case of serious trouble. This sounds like some insurance policy. If it were offered on the free market, such a policy would, however, be dirt cheap for most expatriates, for example those in Canada. This seems like a pure tax grab to me.

Note 1: many countries bill their citizens for repatriation service. Not Canada, which lead to some debates after the last war in South Lebanon. Some people were quite unhappy about subsidizing others living in dangerous places.

Note 2: an obvious solution for expatriates to avoid paying US taxes is to renounce citizenship. It is, however, illegal doing so for tax reason. And in a sly move, the Heroes Act of 2008 which increased benefits to veterans and their survivors also included a provision that anyone giving one's citizenship up voluntarily would be taxed on all assets as if their were sold.

Monday, July 7, 2008

A series of cases have been brought to court recently where illegal immigrants sue abusive employers. The typical reaction on the street: illegal have no right to complain, they should just be deported. Oh, how wrong this attitude is.

First, it is in the self-interest of the local (legal) labor force to see these cases go to court. If employers can continue to abuse illegals workers without impunity, they will prefer hiring illegals over legals. This reduces the demand for legal workers, and thus the number of employed legal residents and/or their wages.

Second, I hold little esteem for any policy that discriminates against the unlucky. The illegal immigrants in question were unlucky in that they were born in the wrong country. Being harassed by the lucky ones is not what I envision as a realization of human society, and specifically human right. It is not a question of an Economist having a heart, think about it an insurance against being born in the wrong place. Illegals should be helped, not discriminated against.

Thursday, July 3, 2008

Monaco has a tiny territory and is bursting. To expand, it seems to have nowhere to go but the sea, à la the Netherlands. And this seems exactly to be the plan: filling up parts of the Mediterranean sea on the shores of Monaco at a cost of €5 billion, to deliver 275,000 square meters of land. This is about US$ 3,000 a square foot. Monaco can do better than that.

The area around Monaco is quite hilly, so I suspect the water is not shallow. This makes it particularly difficult to fill. Also, there may be environmental issues with marine life. I think it would be much simpler to simply expand into existing land, i. e., buy it from neighboring France. And France should be happy to sell.

France should be able to get a good price for it. And it is not losing much. Monaco is a tax tax haven, but not for French nationals. Indeed, after France embargoed Monaco in 1963 because of tax cheats, Monaco had to give in and let France tax its citizens living in Monaco. So no tax revenue loss for France, a apart from the non-French residents that would fall out of its jurisdiction.

Wednesday, July 2, 2008

Two weeks ago, I received an inquiry from Nouriel Roubini's RGE Monitor whether I would be willing to have some of my post featured integrally there. I have let the users of this blog vote on this offer and the results are in. Should I accept this offer?

Yes, anything that publicizes this blog: 13 votes, 38%

Only if money is involved: 6 votes, 17%

No, they want to exploit me: 10 votes, 29%

Whatever: 5 votes, 14%

What do I learn from this? First, there were actually 34 readers who bothered to vote, which is a good start. Second, there is no clear winner. A majority want me to participate (13+6), almost half seem to think serious money needs to be involved (6+10). I interpret this as: Go ahead, but make sure you get a fair cut from the deal.

So, I will now I will wait to hear from a RGE Monitor representative and see what it has to offer for me.

Tuesday, July 1, 2008

Among developed economies, the United States has the most restrictive policy relative to illicit drug. The Netherlands have a much more relaxed one. Guess where more people use drugs.

According to a study published in PLos Medecine, Americans are far ahead of anybody else. this table shows that 16.2% have tried cocaine, New Zealand is second at 4.3%, and the liberal Netherlands have 1.9%. For cannabis, it is 42.4, 41.9% and 19.8%.

So much for the war on drugs. This shows that markets are much more powerful than regulation, they find a way to circumvent rules and laws. How can one really reduce drug use, if this is the true goal? Make it legal, thus reducing its price, as the risk premium drops. Supply will then drop. If the price goes too low, tax it like tobacco and alcohol. At least revenue would then end up in the pockets of the government instead of crooks.